Summary

Yahoo will spin off its non-Alibaba assets (Cash, Yahoo Core and Yahoo Japan stock) instead of spinning off its 15% Alibaba stake into a separate (i.e. Aabaco).

The new spin-off should narrow the tax discount on their BABA and Yahoo Japan holdings to 10%-15% or less from 38%, equivalent to a $9-$14/share boost in Yahoo’s price.

The new spin-off plan is likely to lead to a full sale of all the parts of Yahoo, and bidders may drive the timing, not the board.

Author UpdateToday, 1:05 AM

Yahoo will not be able to pursue a new private letter ruling from the IRS pursuant to a breakup plan for the company because the IRS already declined to rule on the Aabaco spin (learned from our tax counsel). That means the rate limiting factor for the taxable core spin-off (and tax free Yahoo Japan spin-off) is a shareholder vote. The SEC Form 10 process for spin-off filings takes less than six months and so should be completed in time for the June shareholder meeting where the spin-off(s) would presumably be approved.

The board nomination process runs from Feb-March. If shareholders are not voting in June to approve two spin-offs that will be set to take place just days after the June meeting, then we think there is a good chance the board (and management) will be voted out at that same meeting. Then we would expect activist board nominees to remove management and hire bankers to sell the Yahoo core. An unsolicited bid could come at any time for Yahoo overall or one of its parts.

Author’s Note: The article is updated for the confirmation of the spin this morning

Last night Bloomberg (via CNBC/Faber)reported that the board of Yahoo (NASDAQ:YHOO) will announce the cancellation of the spin-off of Aabaco (NYSE:BABA) and this morning the company confirmed in a press release, conference call and CNBC appearance, that it will spin-off it’s non-Alibaba assets. A Yahoo switcheroo!

We are glad to finally see the board take decisive action, in what promises to be the first step in a complete breakup and sale of the company’s parts. No matter how remote the possibility of the Aabaco tax liability, the reverse of the spin-off simply eliminated the risk from the world of possibility. That’s what the market wanted and that’s what the market got.

At most Uncle Sam can require a buck or two per share (i.e. $1-$2bn) in a fully taxable spin/sale of the core, versus the astonishing $16.07/share implied discount as of the close of trading last night. That $16.07/share of implied discount consists of roughly $12.50/share on the Alibaba stock and $3.50/share on the Yahoo Japan stock (OTCPK:YAHOY) (i.e. a 38% discount on both). If we instead apply a 15% discount to each holding, then the per-share figures drop to $5.00 for the Alibaba holding and $1.34 for the Yahoo Japan holding, a total of $6.34.

Yahoo may also simultaneously pursue a spin-off of their Yahoo Japan stake and a sale of the remaining company (remainCo) that will contain cash and the 383mm shares of Alibaba. Both the spin-off of Yahoo Japan and the sale of what we’ll call ‘BABA remainCo,’ seem all but assured now. The timing of these related disposals is not clear at this point, but the calendar for these events may be driven by the prospective buyer(s), not the board.

In their press release, the company has given itself a year or more to complete the process. However, that feels more like sandbagging the timing guidance so that they never find themselves in a position of extending the time frame (as they did when they pushed out the Aabaco spin-off in 3Q15). An SEC Form 10 filing process can take a quarter to go definitive and a private letter ruling request can take two quarters. So, a taxable spin-off could happen by the end of the first quarter, and a tax free spin off could happen by mid year 2017. An unsolicited offer could, of course, come at any time.

The Yahoo Japan spin-off could be part of a spin-merger, where the Yahoo core would be acquired and a Yahoo Japan vehicle spun-off commensurate with the close of the overall merger. Alternatively, Yahoo core could spin, concurrent with or followed by the Yahoo Japan spin.

The value of the Yahoo Japan ($8.5bn) cross-holding is much smaller than the value of the Alibaba cross holding and therefore much more easily handled for tax purposes. The Yahoo Japan shares could be spun-off tax free if Yahoo contributed to a spin-co an active trade or business with roughly $85mm of EBITDA. At a multiple of 5x EBITDA, this active trade or business would be worth $425mm, or approximately 5% of $8.5bn. That would make a Yahoo Japan spin-co eligible for tax free treatment under even the more conservative temporary spin-off guidelines issued by the IRS.

The key idea here is that Yahoo can spin Yahoo Japan with little or no tax issue even under the more conservative temporary guidelines. This is in contrast to the now abandoned Aabaco spin-off, where there simply wasn’t enough EBITDA to available to hit the 5% threshold without absorbing about 35% or more of Yahoo Core EBITDA.

Now the buyout conversation between Alibaba and the BABA remainCo can take place without the same ominous tax overhang. The discussion can instead deal with how the tax synergies (that only BABA can create) are shared between buyer and seller – while still leaving BABA with an accretive deal. Translation? The BABA remainCo gets bought with less of a discount (or no discount if the bidding gets competitive).

Below please find our updated sum of the parts. We estimate that the combined Yahoo is worth $46.30 with a 12% discount applied (29% upside from 12/8/15 YHOO close of $35.80). We get to a 12% discount by applying a 15% holding company discount to both the BABA stock and the Yahoo Japan, respectively. Now that the specter of excess tax has been removed, those assets should trade at more customary holding company discounts (with 15% still being well more conservative than the typical 5-10% range cited by Joe Cornell of Spin-off Research in a recent Forbes article).

We apply a 5x multiple for 2016E core Yahoo EBITDA of $838mm. We’ve seen some very low EBITDA multiples out there. But remember that Yahoo paid about $1.1bn for Tumblr in May of 2013 and 640mm for BrightRoll in November of 2014. Those two assets are probably not worth less than what they paid, but it’s something of an art to back out their respective EBITDA contributions. If they contribute no EBITDA, but we subtract their value from the TEV, then by using a 5x multiple, we actually create a 3x multiple on the left-over (which is still too low).

While a spin is planned, Verizon’s recent positive comments around a prospective M&A of Yahoo core suggest that the company could be acquired even before a core spin-off were to take place. 5x is probably low because we have to think about the core in an M&A context, not solely a publicly traded context. It’s the #3 most visited site on the internet when one combines yahoo mail and yahoo finance, which is (I think) a good example of an asset that can be more valuable to a strategic acquirer than to the troubled corporate itself. In the event of an outright M&A the core could trade for 6-7x EBTIDA, similar to AOL’s takeover multiple.

Below please find an updated sum of the parts analysis:

(click to enlarge)

Below please find the calculations at a 10% discount:

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And again at a 5% discount:

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The Yahoo switcheroo appears to create substantial value by reducing some or all of the tax discount, with the timing of a taxable spin off as early as 1Q16 end or tax free spin as early as 2Q16 end.

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